Playing The Gold/Silver Ratio Four Ways

A picture, it's said, is worth a thousand words. So take a look at the picture below and try to come up with a thousand words to describe what you see:

 

Gold/Silver Ratio Spread

 

The graph's title might offer a clue: It's a head-to-head comparison of trades based on the gold/silver ratio.

We've examined the ratio in a number of articles before, acknowledging that there's more than one way for investors and traders to capitalize upon their expectations for the outperformance of one metal over the other. We've never put the trades side by side, though, to illustrate the actual returns attainable or the risks undertaken. As you can see from the chart above, depending on the approach you take, you can see a BIG difference in returns.

The red line represents the return obtained from using futures (as described in "Metal Spreads Make More Money"), while the blue line describes the gain realized by using exchange-traded metals trusts.

Let's walk through the trades.

First of all, both approaches represent bets on a decline in the gold/silver multiple—the price of an ounce of gold denominated in ounces of silver. On Feb. 1, the price ratio, loco London, was 47.2-to-1. Investors anticipating silver to outperform gold—by either rising more or declining less—would have bought silver and simultaneously sold gold short through futures or exchange-traded securities.

 

Margined Trades

Futures traders could have used the actively traded December contracts in a 3-to-2 ratio—that is, buying three silver contracts (CMX: SIZ) and selling two gold futures (CMX: GCZ)—to qualify for a 50 percent margin credit (see "Metal Spreads Make More Money" for the details). All told, the initial margin requirement would be $24,369.

Alternatively, exchange-traded metals trusts could be employed. For a capital commitment similar to the futures trade, 500 shares of the iShares Silver Trust (NYSE Arca: SLV) could be purchased for cash, while 100 shares of the SPDR Gold Shares Trust (NYSE Arca: GLD) could be sold short in a margin account. The 5-to-1 ratio, insofar as round-lots allow, commits equal dollar exposure to each metal. The capital invested on Feb. 1 would have included $13,935 for the long SLV position and a deposit of $6,540 to secure a short GLD position worth $13,080.

By April 12, after a nearly relentless run-up in silver's dollar value, gold's price had declined to 36.1 times that of silver, engendering the gains depicted in Table 1.

 

Table 1: Futures Vs. Metals Trusts

 

Clearly, these are not equivalent positions. Largely, that's because of the leverage available in the futures trade. Both legs of the futures trade are margined; only the short gold position was leveraged on the securities side.

The degree of leverage was greater with futures, too. Regulation T limits the loan value to 50 percent of the securities' value, while futures leverage isn't restricted by Fed rules. Leverage was further enhanced by the margin credit granted by the futures exchange's clearinghouse. No such breaks are available to securities investors.

 

The securities trade could be further levered by purchasing the SLV shares on margin, but keeping the capital commitment to the $20,000 - $25,000 level would mean trading something less than two round-lots on the gold side. We'll forego additional leverage for now.

The futures position's higher downside variance also reflects leverage. The mean daily return for the futures position was 4.5 percent; on the securities side, it was 0.4 percent. Day-to-day futures losses, just like gains, were magnified. There were fewer days, too, in which losses were booked on the futures side—34 percent vs. 42 percent for the securities spread.

The reward-to-risk ratio measures the period return against the position's annualized volatility. Noting this, we can say that the futures trade may be four times riskier (measured by the size, but not the frequency, of day-to-day drawdowns), but that added risk is more than compensated by a leveraged return.

 

Unlevered Trades

Futures trades are not suitable for every investor. Neither is margin. Luckily, the gold/sliver ratio can be traded in a cash account with exchange-traded securities. The iShares SLV trust, for example, could have been purchased together with a position in the PowerShares DB Gold Short ETN (NYSE Arca: DGZ) in a 4-to-7 ratio. The DGZ note seeks to track the monthly performance of a single short gold futures contract.

For a capital outlay of $22,355 on Feb. 1, investors could obtain roughly equal dollar exposure to long silver and short gold. By April 12, the net position would have gained 16 percent with an annualized downside variance of 8.5 percent.  The average daily return was 0.3 percent, though 38 percent of daily returns were losses.

Just because you can't use margin doesn't mean you can't enjoy leverage. You can double your dollars' effective shorting power by using the PowerShares DB Gold Double Short ETN (NYSE Arca: DZZ), which purports to offer two times the monthly short performance of gold futures.

With that leverage, $21,055 could have been divided between SLV and DZZ in a 5-to-8 ratio on Feb. 1, producing a 21.3 percent gain by April 12. Downside variance would have been clocked at 11.2 percent, with average daily gains of 0.4 percent.

 

Gold/Silver Ratio Spreads With ETNs

 

Table 2: SLV Trust With Gold ETNs

 

Conclusion 

The clear standout among the four positions we've examined is the futures spread. Traders looking to get the most bang for their bucks when playing the gold/silver ratio—in either direction—would be better off using a commodity account if they can.

The proof's in the pictures.